What the headlines are not telling us

Keeping track of the state of the markets and the economy can be a challenging task at the best of times, but the news flow from the press can make this even more difficult. As an example I quote from the Financial Times from 17 October: “Mounting optimism bolsters markets’ moods”.

The article goes on to say that the forecast-beating corporate earnings and robust economic data have heightened investor optimism. A subsequent article on the 21 October headlined “Upbeat start to earnings season”, stating that corporate America issued a string of quarterly earnings results which exceeded Wall Street expectations. These two articles were however followed by “Strong results fail to shift the mood of caution” on 24 October. There was either a huge turnaround in the mood of the market in the space of a week, or else market participants are beginning to doubt the pace of market gains, and questioning whether it can continue, despite all of the “positive” news flow.

At the time of writing we are about halfway through the third quarter earnings season. There has been an interesting reaction by the market to what appears to be a blowout quarter, at least on the surface. The ratio of companies that beat expectations to those that missed has been over six. This is the highest since the third quarter of 2002.

It appears that companies are either doing really well in what can only be termed an OK economy, or the expectations are not realistic. While company guidance appears to be on the cautious side, delving into the numbers we see that although companies are beating on the expected bottom line figure, we aren’t seeing the same outperformance when it comes to the revenue numbers.

The beat/miss ratio for revenue is below two. The reason for this is the fact that companies are beating expectations through massive cost cutting exercises, but the question remains as to how long this can be sustained? A number of large Blue Chip companies which beat expectations were nevertheless down a week after results. It appears as if investors are beginning to look for the top line growth as evidence that the green shoots of recovery are starting to blossom.

A valuation metric often used to value individual stocks and the market as a whole, is the Price to Earnings (P/E) ratio. As the name implies, this is the price of the stock divided by the earnings. If the price increases without a corresponding increase in earnings, then the ratio will go up. Along with the 50% increase in the market which we have witnessed since March, the P/E ratio of the S&P 500 is now in excess of 20. In comparison the ratio was around 17 just before the collapse of Lehman Brothers in September last year. The historical average going back to 1954 is 16.36. It follows that, in order to sustain the current level, we will need to see a sharp bounce in operating profits, driven by a broader based sales pickup, rather than purely the cost control measures as witnessed in the current quarter.

Based on the above historical comparisons, the market appears to be expensive. We have heard commentators saying that this time it’s different. This might be so, but the economic data to support this has thus far proven to be less than convincing. We have seen the bad news level off and even show some signs of improving, but the test will come in January, when the fourth quarter results are announced and the market begins to demand an improvement in top line growth. This remains to be seen, but with equity market valuations priced for a perfect economic recovery, investors should be cautious and selective in their approach.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited.  The Bank accepts no liability for errors or actions taken on the basis of this information.



Stock Watch by Butterfield Bank’s Mark Fagan